Trading Practices and Errors

January 1, 2012

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Trade allocation policies and procedures are necessary, even if an RIA does not believe clients are in danger. During routine examinations, the SEC and other regulators scrutinize trade allocation practices, because there is a potential for clients to be harmed or defrauded. They also examine whether an RIA has thorough and effective policies and procedures for resolving trading errors. An RIA should fully disclose on Form ADV its trade allocation practices, as well as the mechanism the firm uses to resolve trading errors.

Trade Allocation Practices

An RIA’s trade allocation practices should not come as a surprise to clients. Furthermore, an RIA may defraud its clients when it disproportionately allocates potentially lucrative initial public offerings (IPOs) to favored accounts and fails to adequately disclose this practice to all clients. Allocations of IPOs may be inequitable when preference is given to the following:

Proprietary accounts

Accounts that pay performance-based fees

Accounts that are underperforming

Clients that the RIA hopes will invest more money with the firm

For example, suppose an RIA manages the account of a multi-millionaire. The RIA’s current fee is a percentage of the two million dollars in the client’s account with the advisory firm. Because the IAR handling the account knows that the client has millions of dollars more that might be invested, she allocates all promising IPOs to that client.

An RIA should never wait for subsequent market movements before deciding how to allocate trades among clients. Regulators are concerned that the RIA might allocate the trades to favored clients if prices go up and allocate the trade to less-favored clients if the price goes down, which violates the Investment Advisers Act.

RIAs may harm their clients if they fail to use the average price paid when allocating securities to accounts participating in bunched trades. In addition, firms must fully disclose their allocation policies.

Trading Errors

A trading error is defined as an error in the placement, execution, or settlement of a client’s trade. It is not a trading error if the mistake is corrected before the trade is settled. Although inevitable trading errors will occur, the real damage is done when an RIA fails to address and handle them appropriately.

The following are examples of trading errors:

Trading a security for the wrong account

Trading the wrong security

Over-allocation of a security

Buying or selling an incorrect amount of a security

Purchasing rather than selling a security

Failing to buy or sell a security as directed by a client

Buying or selling an unauthorized security

Buying a security that is not aligned with a client’s investment objectives

Buying or selling a security that violates a restriction on the client’s account

It is important to recognize that trading errors do not include:

errors that are detected and corrected prior to settlement;

ticket rewrites and similar mistakes;

errors made by persons and companies other than the advisor, such as broker-dealers;

poor investment decisions; and

intentional acts.

It is not a trading error if an IAR intentionally invests in a security other than the one the client asked him to buy. This is a serious breach of the legal obligations owed to a client. The IAR most likely breached his fiduciary obligations to the client and may expose himself and the firm to legal action.

A trading error does not include a situation where an RIA recommends a particular investment that does not perform as expected. Such an occurrence, which happens quite frequently, is a bad investment choice and not a trading error.

The Consequences of Trading Errors

If handled improperly, trading errors may cause an advisory firm to violate the Investment Advisers Act. Several years ago, the SEC sanctioned a California RIA for wrongful conduct related to trading errors for making a stock trading error resulting in a loss of $400,000. Instead of absorbing the loss from the trading error, the RIA passed it along to clients. By doing so, the RIA violated Sections 206(1) and 206(2) of the Investment Advisers Act, the anti-fraud sections of the statute. These are the most serious violations an RIA can commit.

In that proceeding, the SEC made it clear that losses caused by an RIA’s trading error should not be the client’s responsibility. Passing along these losses to clients clearly breaches the RIA’s fiduciary obligation. The SEC will discipline an RIA for attempted concealment of a trading error.

RIAs Obligations Relating to Trading Errors

As part of their compliance obligations, RIAs must create and retain trading error books and records. These trading error records should explain what errors occurred, how they were corrected, and must be maintained for five years.

When SEC or state examiners come for a visit, they ask for information regarding trading errors committed by the RIA. In its Examination Information Request List, the SEC asks for a list of trading errors, which occurred in client or proprietary accounts during the inspection period. This information is found in the RIA’s trade blotter (purchases and sales journal), which lists all transactions including trading errors.

An RIA must retain records of all trading errors including the:

transaction date;

security;

account and broker-dealer involved; and a

summary of the error and its ultimate disposition, including the conditions of any financial settlement.

Trading errors do not necessarily harm the client. In some cases, a mistake may actually improve the client’s return on investment. RIAs must fully disclose on Form ADV how they resolve trading errors that benefit the client. Some RIAs choose to retain the profits arising from the mistake, and others reallocate them to a trading error account or a designated charity.

Policies and Procedures Relating to Trading Errors

An RIA’s policies and procedures should specifically address trading errors and how they are handled. Furthermore, an RIA’s compliance manual should set forth the notification procedure to be followed after the error is discovered. These policies and procedures should state explicitly that the client will be made whole if losses from trading errors occur.

In theory, an RIA could take the position that the firm won’t reimburse clients for losses resulting from trading errors. Even if the RIA fully discloses that it will not take responsibility for trading errors, securities regulators will still react negatively to this practice. In all probability, the RIA would be sanctioned by regulators and might face legal action brought by the client who lost money due to the error. Regardless of the cost to the RIA, however, clients should never suffer a loss resulting from a trading error.

If an RIA reallocates or corrects an error from one client account to another, it must absorb any loss. Once identified, an attempt should be made to correct it that same day.

Soft dollar arrangements may not be used to correct mistakes made by an RIA when placing a trade for a client’s account. The SEC’s soft dollar interpretive release, which we discussed in Nothing but the Best Execution, concluded that the brokerage services safe harbor does not include products and services used to correct trading errors. According to the release, “error correction trades or related services in connection with errors made by money managers are not related to the initial trade for a client within the meaning of Section 28(e)(3)(C) because they are separate transactions to correct the manager’s error, not to benefit the advised account.” These products and services are viewed as overhead.

Form ADV Disclosures

An RIA’s Form ADV Part 2A disclosure brochure should describe the firm’s policy regarding trade errors. Typically, an RIA’s policy is to restore the client’s account to the position it should have been in had the trading error not occurred. Depending on the circumstances, corrective actions may include canceling the trade, adjusting an allocation, and/or reimbursing the account.

Conversely, Form ADV should disclose what actions an RIA will take if a trade error results in a profit. In many cases, an RIA takes the position that if a trade error results in a profit, the client will keep the proceeds. Another option is for the RIA to state that if a trade error results in a profit, it will be corrected in the trade error account of the executing broker-dealer and the RIA will not keep the profit.

The Big Picture

When an SEC-registered investment advisor conducts its annual audit of the firm’s policies and procedures, it should pay special attention to trading practices. Although state-registered investment advisors are not usually required to conduct an annual audit, they benefit by looking at their trading policies and procedures. If these policies do not fully protect their clients, they should be revised accordingly.

Forensic tests can be utilized to identify unusual trading patterns. For example, similarly managed accounts should produce similar results if all other factors like deposits and withdrawals are equal. If the results are very different, it might mean that the RIA is favoring certain accounts or misallocating investment opportunities. Forensic tests can also detect whether an RIA is overtrading.

Rule 204-2(a)(3) requires RIAs to maintain a memorandum of each order they give for the purchase or sale of any security. The memorandum must contain specific information about these transactions. RIAs have been sanctioned if their trade tickets failed to indicate whether the order was entered pursuant to the exercise of discretionary power, the person connected with the firm who recommended the transaction, and the person who placed the order.

It’s not the worst mistake in the world for an RIA to commit a trading error. The real problem for an RIA is failing to resolve an error in an appropriate manner.

Les Abromovitz

Les Abromovitz is the author of The Investment Advisor’s Compliance Guide, published for 2012 by The National Underwriter Company/Summit Business Media. Les Abromovitz is an attorney and member of the Pennsylvania bar. Les has handled hundreds of consulting and publishing project for a leading compliance and regulatory services firm. He has conducted a number of seminars and training sessions dealing with compliance subjects. Les is also the author of several White Papers that analyze compliance issues impacting Registered Investment Advisors (RIAs).

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